TSX hits my target! Now what?

All the way back in May I made the bold prognostication (read: wild guess) that the TSX should be valued at between 11,400 and 11,500 - up from about 10,200 at the time. I hazarded a guess that the TSX might get to that level by the end of 2009, however it decided not to wait until the end of the year, closing at 11,496 today.

In my previous post I suggested that the market was undervalued and would be pricing in 2009 TSX earnings of about $575 per share. I then applied a long-run average PE multiple of about 20 to arrive at my call of 11,400-11,500.

Current estimates for 2010 corporate profits are in a range of 5-10% growth. My own model of corporate profits is spitting out growth of 30% (which I don't quite believe) - so lets say TSX EPS of around $630-$750. Since so much depends on the multiple applied to these profits, i've made a quick and dirty attempt at incorporating a PE equation based on short and long-term interest rates and nominal GDP growth into my Canadian economy model. The model derived PE suggests an average multiple of between 17-18 over the next year. Applying this multiple to the above range of forward earnings gives a fair value for the TSX of between 11,400 and 13,500, suggesting a market going sideways or a market about to pop by about 20%. A big range to be sure, but perhaps that is consistent with the amount of uncertainty in stock prices.

Could I have arrived at this range by pulling numbers randomly out of a hat? Probably, but what fun would that be?

What's going on with the yield curve?

Milton Friedman famously proclaimed that “inflation is always and everywhere a monetary phenomenon”, implying that inflation is inextricably linked to the money supply. This thinking has lead some analysts and others to voice heightened fear that monetary stimulus provided by the Bank of Canada, and the Federal Reserve in the United States, can only lead to a resurgence in inflation.

Proponents of this view point to the recent increase in the slope of the government yield curve as a clear signal that purchasers of government treasuries, fearful of the impact of massive monetary and fiscal stimulus, are ratcheting up their inflation expectations and demanding a higher yield on long-term debt. Still others view the steepening yield curve as a positive signal of expected future growth and the end of the recession. So which is it?
Looking at inflation expectations derived from Canadian real-return bonds, it is pretty difficult to conclude that Canadians, or buyers of Canadian debt, expect runaway inflation on the horizon. Inflation expectations seem to have ticked up recently, but I think only because a Great Depression II induced deflationary spiral seems to be off the table. Moreover, expectations remain firmly anchored in the BoC comfort range

It is also hard to conceive of a scenario in which inflation could get out of control while the economy is operating so far below its potential.


My own opinion is that the increase in the slope of the yield curve is a function of the following factors (in no particular order):

1) Flight from quality – investors getting out of treasuries and back into riskier assets

2) Normalized inflation expectations – fears of a deflationary spiral seems to have been successfully beaten back by the Bank of Canada

3) Expected Government borrowing due to larger than anticipated fiscal deficits

4) Expectations that the worst of the recession is over and the economy will return to positive growth soon.

Minsky and Haircuts

Ezra Klein links to an interesting paper by Gary Gorton of Yale University. In that paper, Gorton describes how the subprime crisis is linked to runs on other structured products through the repo market. A sale and repurchase agreement ('repo' for short) involves a short term swap of collateral (t-bills, etc) for cash - the value of the transaction is discounted by some margin known as a haircut.

For example, Bank A wants to raise cash and pledges an asset worth $100 as collateral. Bank B takes the asset and gives Bank A $98 in cash. The $2 difference is the haircut and depends on the credit risk of the counterparty.

Here is where Hiram Minsky enters the picture - look at the graph below from Gorton's paper:


Klein makes the point that it is not the spike in haircuts demanded that is troubling, it is the period of extremely low haircuts just prior to the crisis. Minsky warned that such periods of calm betray extreme underestimation, and hence underpricing, of risk that eventually leads to crisis, asset fire-sales and flight to quality - a scenario that Paul McCulley of PIMCO termed a "Minsky Moment". A smaller scale example of a Minsky Moment is the collapse of the hedge fund LTCM in 1998. Followers of that story may recall that LTCM convinced its counterparties to allow them to borrow without taking a haircut on collateral. We all know how that ended.

I haven't seen any research exploiting the potential predictive information in haircuts, credit spreads, etc in detecting a rising probability of these Minsky Moments. Given the recent rediscovery and surging popularity of Minsky (I certainly had never heard his name in all my years studying economics) perhaps some enterprising economist is already working on it.

Is the TSX Fairly Valued?

Canada's stock market has been on somewhat of a roll lately, rising about 35% to 10,238 from a 2009 low of 7,566. In this post I'm going to attempt something fairly pointless - trying to figure out whether the TSX/S&P is overvalued, undervalued, or valued about right.

A common methodology used to make broad stock market calls involves assigning a multiple to a forward estimate of TSX earnings. TSX composite earnings as of December 2008 were about $830 and the forecast range for corporate earnings for 2009 is a decline of between 15%-31%, suggesting a 12 month forward estimate for 2009 of between $575-$699. The former seems much more likely to me.

What is the right multiple? Hard to say. Earnings multiples tend to get compressed in recessions before increasing as the economy recovers and investors regain confidence in equities. The TSX is currently trading at around 12x current earnings, which is similar to multiples observed in the beginnings of previous recessions.

The average TSX P/E ratio since 1956 is about 20x. Applying this long-run average P/E to the range of forward earnings estimates gives a market valuation at the end of 2009 of between 11,484 and 13,980 which implies that the market is currently between 11% and 27% undervalued.

I'm more sympathetic to the low-end of the corporate earnings forecasts so i'll conclude with a market call of 11,400-11,500 by the end of 2009.

This is not investment advice

...but if we have the soundest financial system in the world, doesn't it seem like now might be a good time to buy Canadian financials?